June 01, 2022 June 01, 2022/ Steven Bragg
The accounting for investments occurs when funds are paid for an investment instrument. The exact type of accounting depends on the intent of the investor and the proportional size of the investment. Depending on these factors, the following types of accounting may apply:
Held to Maturity Investment
If the investor intends to hold an investment to its maturity date (which effectively limits this accounting method to debt instruments) and has the ability to do so, the investment is classified as held to maturity. This investment is initially recorded at cost, with amortization adjustments thereafter to reflect any premium or discount at which it was purchased. The investment may also be written down to reflect any permanent impairments. There is no ongoing adjustment to market value for this type of investment. This approach cannot be applied to equity instruments, since they have no maturity date.
Trading Security
If the investor intends to sell its investment in the short-term for a profit, the investment is classified as a trading security. This investment is initially recorded at cost. At the end of each subsequent accounting period, adjust the recorded investment to its fair value as of the end of the period. Any unrealized holding gains and losses are to be recorded in operating income. This investment can be either a debt or equity instrument.
An available for sale investment cannot be categorized as a held to maturity or trading security. This investment is initially recorded at cost. At the end of each subsequent accounting period, adjust the recorded investment to its fair value as of the end of the period. Any unrealized holding gains and losses are to be recorded in other comprehensive income until they have been sold.
Equity Method
If the investor has significant operating or financial control over the investee (generally considered to be at least a 20% interest), the equity method should be used. This investment is initially recorded at cost. In subsequent periods, the investor recognizes its share of the profits and losses of the investee, after intra-entity profits and losses have been deducted. Also, if the investee issues dividends to the investor, the dividends are deducted from the investor's investment in the investee.
Realized Gains and Losses
An important concept in the accounting for investments is whether a gain or loss has been realized. A realized gain is achieved by the sale of an investment, as is a realized loss. Conversely, an unrealized gain or loss is associated with a change in the fair value of an investment that is still owned by the investor.
There are other circumstances than the outright sale of an investment that are considered realized losses. When this happens, a realized loss is recognized in the income statement and the carrying amount of the investment is written down by a corresponding amount. For example, when there is a permanent loss on a held security, the entire amount of the loss is considered a realized loss, and is written off. A permanent loss is typically related to the bankruptcy or liquidity problems of an investee.
An unrealized gain or loss is not subject to immediate taxation. This gain or loss is only recognized for tax purposes when it is realized through the sale of the underlying security. This means that there may be a difference between the tax basis of securities and their carrying amount in the accounting records of the investor, which is considered a temporary difference.
June 01, 2022/ Steven Bragg/
Investments accounted for under the equity method for financial reporting purposes, pursuant to ASC 323, Investments—Equity Method and Joint Ventures, are generally recorded at cost basis for tax purposes. As a result, as the investor’s share of an investee’s earnings are accrued for book purposes through application of the equity method, a temporary difference arises between the book and tax bases for these investments.
ASC 740-30-25-5(b) requires recognition of a deferred tax liability for the excess book-over-tax basis of an investment in a 50%-or-less-owned investee. Therefore, the outside book-over-tax basis in the investment should result in a deferred tax liability. In addition, because the additional “reverse in the foreseeable future” criterion in ASC 740-30-25-9 (see TX 11.5) does not apply to foreign or domestic unconsolidated investees, the outside tax-over-book basis for such an investment should generally result in a deferred tax asset.
ASC 740-30-25-18 provides an exception to recording a deferred tax liability for an outside basis difference in a corporate joint venture that is essentially permanent in duration. However, a corporate joint venture that is not permanent in duration is substantively the same as any other equity investment.
Based on ASC 740-10-55-24, the measurement of deferred tax liabilities and assets depends on the expected type of taxable or deductible amounts in future years. That is, it depends on how the investment will ultimately be realized (e.g., through dividends, sale, or liquidation). In providing deferred taxes, understanding the expected form of realization by the investor—dividends vs. capital gains—is often critical. See TX 11.8.2 for further discussion.
The outside basis difference is calculated by comparing the tax basis of the stock to the book basis of the investment. While determining the tax basis (i.e., cost) of the stock is generally straightforward, complexities often arise when applying the equity method to determine the book basis. EM 3.3 provides further guidance on this allocation process and determining the underlying equity in the net assets of the investee.
Even though the results of the equity method investee are generally reported in investor’s financial statements net of the investee’s tax expense, the income tax provision of an investor in an equity investment should only include the investor’s tax consequences from the investment—i.e., the current and deferred tax effects associated with its share of the investee’s earnings. As these tax effects are those of the investor, not the investee, they should be recognized in the investor’s tax provision, not offset within the investor’s equity in net earnings of the investee.
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An investor records an impairment charge in earnings when the decline in value below the carrying amount of its equity method investment is determined to be other than temporary. “Other than temporary” does not mean that the decline is of a permanent nature. The unit of account for assessing whether there is an other-than-temporary impairment (OTTI) is the carrying value of the equity method investment as a whole.
ASC 323-10-35-32
A loss in value of an investment that is other than a temporary decline shall be recognized. Evidence of a loss in value might include, but would not necessarily be limited to, absence of an ability to recover the carrying amount of the investment or inability of the investee to sustain an earnings capacity that would justify the carrying amount of the investment. A current fair value of an investment that is less than its carrying amount may indicate a loss in value of the investment. However, a decline in the quoted market price below the carrying amount or the existence of operating losses is not necessarily indicative of a loss in value that is other than temporary. All are factors that shall be evaluated.
Continued operating losses at the investee may suggest that the investor would not recover all or a portion of the carrying value of its investment, and therefore that the decline in value is other than temporary.
ASC 323-10-35-31
A series of operating losses of an investee or other factors may indicate that a decrease in value of the investment has occurred that is other than temporary and that shall be recognized even though the decrease in value is in excess of what would otherwise be recognized by application of the equity method.
All available evidence should be considered in assessing whether a decline in value is other than temporary. The relative weight placed on individual factors may vary depending on the situation.
Factors to consider in assessing whether a decline in value is other than temporary include:
The length of time (duration) and the extent (severity) to which the market value has been less than cost.
The financial condition and near-term prospects of the investee, including any specific events which may influence the operations of the investee, such as changes in technology that impair the earnings potential of the investment or the discontinuance of a segment of the business that may affect the future earnings potential.
The intent and ability of the investor to retain its investment in the investee for a period of time sufficient to allow for any anticipated recovery in market value.
Investors should also consider the reasons for the impairment and the period over which the investment is expected to recover. The longer the expected period of recovery, the stronger and more objective the positive evidence needs to be in order to overcome the presumption that the impairment is other than temporary. As the level of negative evidence grows, more positive evidence is needed to overcome the need for an impairment charge. The positive evidence should be verifiable and objective.
Figure EM 4-2 contain examples of negative evidence that may suggest that a decline in value is other than temporary. Figure EM 4-3 contains examples of positive evidence that may suggest a decline in value is not other than temporary. These examples are not all-inclusive, and investors should assess all relevant facts and circumstances.
Figure EM 4-2
Negative evidence that indicates decline is other than temporary
A prolonged period during which the fair value of the security remains at a level below the investor’s cost
The investee’s deteriorating financial condition and a decrease in the quality of the investee’s asset, without positive near-term prospects for recovery. For example, adverse changes in key ratios and/or factors, such as the current ratio, quick ratio, debt to equity ratio, the ratio of stockholders’ equity to assets, return on sales, and return on assets. With respect to financial institutions, examples of adverse changes are large increases in nonperforming loans, repossessed property, and loan charge-offs.
The investee’s level of earnings or the quality of its assets is below that of the investee’s peers
Severe losses sustained by the investee in the current year or in both current and prior years
A reduction or cessation in the investee’s dividend payments
A change in the economic or technological environment in which the investee operates that is expected to adversely affect the investee’s ability to achieve profitability in its operations
Suspension of trading in the security
A qualification in the accountant’s report on the investee because of the investee’s liquidity or due to problems that jeopardize the investee’s ability to continue as a going concern
The investee’s announcement of adverse changes or events, such as changes in senior management, salary reductions and/or freezes, elimination of positions, sale of assets, or problems with equity investments
A downgrading of the investee’s debt rating
A weakening of the general market condition of either the geographic area or industry in which the investee operates, with no immediate prospect of recovery
Factors, such as an order or action by a regulator, that (1) require an investee to (a) reduce or scale back operations or, (b) dispose of significant assets, or (2) impair the investee’s ability to recover the carrying amount of assets
Unusual changes in reserves (such as loan losses, product liability, or litigation reserves), or inventory write-downs due to changes in market conditions for products
The investee loses a principal customer or supplier
Other factors that raise doubt about the investee’s ability to continue as a going concern, such as negative cash flows from operations, working-capital deficiencies, or noncompliance with statutory capital requirements
The investee records goodwill, intangible or long-lived asset impairment charges
Figure EM 4-3
Positive evidence indicating decline is not other than temporary
Recoveries in fair value subsequent to the balance sheet date
The investee’s financial performance and near-term prospects (as indicated by factors such as earnings trends, dividend payments, analyst reports, asset quality, and specific events)
The financial condition and prospects for the investee’s geographic region and industry
In situations where the fair value is known, such as in the case of an investment with a quoted price or when an investee stock transaction occurs, and that fair value is below the investor’s carrying amount, the investor would need to assess whether that impairment is other than temporary. The fact that the fair value is below the carrying amount does not automatically require an impairment charge to be recognized. All facts and circumstances would need to be considered.
Excerpt from ASC 323-10-35-32
A current fair value of an investment that is less than its carrying amount may indicate a loss in value of the investment. However, a decline in the quoted market price below the carrying amount or the existence of operating losses is not necessarily indicative of a loss in value that is other than temporary. All are factors that shall be evaluated.
For investments in private companies, information that would usually be considered includes:
The price per share of the most recent round of equity investments
The expected timing of the next round of financing
The history of operating losses and negative cash flow
Earnings and cash flow outlook and expected cash burn rate
Technological feasibility of the company’s products
Once a determination is made that an OTTI exists, the investment should be written down to its fair value in accordance with ASC 820 at the reporting date, which establishes a new cost basis. Any bifurcation of declines in value between “temporary” and “other than temporary” is not allowed. Subsequent declines or recoveries after the reporting date are not considered in the impairment recognized. A previously recognized OTTI also cannot subsequently be reversed when fair value is in excess of the carrying amount.
When an investor records an OTTI charge, the investor is required to attribute the impairment charge to the underlying equity method memo accounts of its investment. The attribution may create new basis differences or impact existing basis differences. ASC 323 does not provide guidance on attributing the amount of an OTTI charge to the investor’s equity method memo accounts. We believe there are several acceptable methods to attribute the charge; however, the method applied should be reasonable given the nature of the OTTI charge. Two acceptable methods include the specific identification method and the fair value method. Under the specific identification method, the investor would create a new basis difference or adjust an existing one for the specific items (e.g., litigation) that resulted in the OTTI charge. Under the fair value method, the investor would reset all its basis difference as if the investor had acquired the investment on the date of recording the OTTI charge.
Example EM 4-11 illustrates the adjustment of an existing basis difference under the specific identification method.
EXAMPLE EM 4-11
Subsequent accounting for negative basis differences created by an impairment charge
In 20X1, Investor acquired a 40% investment in Investee (a public company) for $25 million. At the date of the acquisition, the book value of the net assets of Investee totaled $50 million and the fair value of the net assets totaled $62.5 million. The assets held by Investee consisted primarily of net current assets with a carrying value and fair value of $30 million and long-lived assets with remaining useful lives of 10 years, a carrying value of $20 million, and a fair value of $32.5 million. As a result, the carrying value of Investor’s proportionate interest in the net assets of Investee was $20 million. The $5 million basis difference was attributed entirely to fixed assets.
Five years later (i.e., in year 20X6), Investee lost the contract of a significant customer and experienced some production issues. No impairment charge was recorded within Investee’s financial statements (impairment was tested under the long-lived asset impairment model using the undiscounted future cash flows, which were in excess of the book value of the assets). However, the market price per share of Investee declined below Investor’s investment balance per share, representing a potential impairment of $5 million. Based on all available information, Investor concluded that the decline in value of Investee’s market price per share was other than temporary. For simplicity, all tax implications are ignored.
How should Investor subsequently account for negative basis differences created by an impairment charge?
Analysis
Assuming Investor determines that the decline in value of $5 million is other than temporary, Investor would record an impairment charge of $5 million against the investment in Investee.
Given the nature of Investee’s operations and asset base (principally working capital and fixed assets), this loss could be considered attributable to Investee’s fixed assets. As a result, the impairment charge would eliminate the remaining fixed asset basis difference of $2.5 million ($5.0 million × 5/10 years amortized), and create an additional $2.5 million negative basis difference.
The negative basis difference would be amortized over the remaining asset lives. Investor would need to determine the appropriate amortization period. While there are 5 years remaining of the original 10-year useful life determined at the date of the initial investment, the estimated remaining lives of Investee’s fixed assets at the date of impairment should be considered in determining the appropriate amortization period. For this example, we have assumed 5 years.
Investee’s net income would include $2,000,000 of depreciation expense ($20,000,000 [investee’s carrying value of its fixed assets]/10 years [estimated useful life]), which reflects the carrying value of the fixed assets as reported in Investee’s financial statements. Investor would recognize its proportionate share of Investee’s net income; however, Investor should also amortize $500,000 ($2.5 million/5 years) of the negative basis difference as an increase (credit) to equity method earnings in order to reflect Investor’s lower cost basis in Investee’s fixed assets, which results in lower annual depreciation expense.